Tax Gap: Actions That Could Improve Rental Real Estate Reporting Compliance
Highlights
As part of its most recent estimate of the tax gap, for tax year 2001, the Internal Revenue Service (IRS) estimated that individuals underreported taxes related to their rental real estate activities by as much as $13 billion. Given the magnitude of underreporting, even small improvements in taxpayer compliance could result in substantial revenue. GAO was asked to provide information on rental real estate reporting compliance. This report (1) provides information on the extent and primary types of taxpayer misreporting of rental real estate activities and (2) identifies challenges IRS faces in ensuring compliance and assesses options for increasing compliance. For estimates of taxpayer misreporting, GAO analyzed a probability sample of examination cases for tax year 2001 from IRS's most recent National Research Program (NRP) study of individual taxpayer compliance.
At least an estimated 53 percent of individual taxpayers with rental real estate misreported their rental real estate activities for tax year 2001, resulting in an estimated $12.4 billion of net misreported income. This amount of misreporting is understated because IRS knows it does not detect all misreporting during its NRP examinations and adjusts the amount of misreporting it detects to estimate the tax gap. Also, the rate of misreporting of rental real estate activity was substantially higher than for some other sources of income, such as wages, a disparity that undermines the fairness of the tax system. Misreporting of rental real estate expenses was the most common type of rental real estate misreporting. Limited third-party information reporting for rental real estate activity is among the challenges IRS faces in ensuring compliance for rental real estate reporting. While information reporting, such as financial institutions sending information to IRS about taxpayers' mortgage interest payments, improves compliance, it is not practical to implement and enforce broad, new information reporting requirements for rental real estate activities. However, improving existing information reporting requirements is one of various options that could improve compliance. For example, based on current law, whether rental real estate property owners must file information returns for certain expenses they incur depends on whether the owners' rental activities are considered a trade or business, but the law does not define how to make this determination. Another approach to improving compliance is to require taxpayers to report additional detail about their rental real estate activities on tax returns. For example, requiring taxpayers to report complete property address information, which GAO found that some taxpayers did not report, could help IRS address misreporting. Requiring additional detail on tax returns could also compel paid tax return preparers, used by about 80 percent of individual taxpayers who report rental real estate activity, to obtain more accurate information from taxpayers. Enhanced IRS guidance, such as on required recordkeeping, and additional IRS outreach to paid preparers and others about rental real estate misreporting could also improve compliance.
Recommendations
Matter for Congressional Consideration
| Matter | Status | Comments |
|---|---|---|
| To provide clarity for which taxpayers with rental real estate activity must report expense payments on information returns and to provide greater information reporting, Congress may wish to consider amending the Internal Revenue Code to make all taxpayers with rental real estate activity subject to the same information reporting requirements as other taxpayers operating a trade or business. | No legislative action had been taken, as of March 1, 2024, to make owners of rental real estate subject to the same payment reporting requirements regardless of whether they engaged in a trade or business under current law, as GAO recommended in August 2008. Changing reporting requirements and holding taxpayers with rental real estate to the same filing requirements as taxpayers whose activities are considered a trade or business would provide clarity about who is required to file, which would improve tax compliance and result in increased revenue. |
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Internal Revenue Service | To help IRS identify taxpayers who may have misreported their rental real estate activity, the Commissioner of Internal Revenue should require third parties to report mortgaged property addresses on Form 1098 mortgage interest statements. |
Legislative and executive actions have been taken that addresses this recommendation. In July 2015, Congress enacted the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Public Law 114-41). Section 2003 of the act requires persons receiving mortgage interest payments to report the property's address. This new reporting requirement applies to returns and statements made after December 31, 2016 (returns that would be filed in 2017). In response to the legislation, IRS included a place to report this information on the 2016 edition of Form 1098 Mortgage Interest Statement. The new form is available for the 2017 filing season.
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| Internal Revenue Service | To elicit more accurate information from taxpayers on their rental real estate activities, the Commissioner of Internal Revenue should require taxpayers to report on the individual tax return the basis amount attributed to land versus structure when depreciating rental real estate. |
IRS considered this recommendation but ultimately decided not to adopt it because requiring taxpayers to report basis information is not legislatively mandated and IRS states it does not need the information for tax administration.
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| Internal Revenue Service | To elicit more accurate information from taxpayers on their rental real estate activities, the Commissioner of Internal Revenue should determine if IRS uses property type information that taxpayers currently report on Schedule E in its efforts to enforce rental real estate reporting compliance, and if it is determined that IRS uses the information, the Commissioner should require taxpayers to provide specific information on Part I of Schedule E about the type of properties for which they are reporting activity, for example by answering a check-the-box question, and if it is determined that IRS does not use the information, the Commissioner should not require taxpayers to report any property type information. |
IRS determined that it uses property type information that taxpayers report on Schedule E in enforcing rental real estate tax compliance. For tax year 2011, IRS changed Part I of Schedule E. Taxpayers are asked to select from 1 of 8 property type codes listed on the form and enter a property type code on the form for each of their rental properties. The listed property type codes are single family residence, multi-family residence, vacation/short-term rental, commercial, land, royalties, self-rental, and other (which the taxpayer is asked to describe).
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| Internal Revenue Service | To elicit more accurate information from taxpayers on their rental real estate activities, the Commissioner of Internal Revenue should require taxpayers to report the exact "address" of their rental real estate properties on Part I Schedule E instead of property "location," as currently worded, and require taxpayers to report property zip codes. |
IRS revised the wording on the tax year 2008 versions of Part I of Schedule E and the instructions to the schedule to require taxpayers to report property addresses and zip codes.
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| Internal Revenue Service | To help taxpayers understand the requirements related to certain aspects of reporting rental real estate activities, the Commissioner of Internal Revenue should include guidance within the instructions to Part I of Schedule E on the requirement for some taxpayers with rental real estate activity to report on Form 1099-MISC certain payments made in the course of renting out real estate. |
The Internal Revenue Service included guidance on filing information returns in the tax year 2008 instructions to Schedule E.
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| Internal Revenue Service | To help taxpayers understand the requirements related to certain aspects of reporting rental real estate activities, the Commissioner of Internal Revenue should include guidance within the instructions to Part I of Schedule E on resources available to taxpayers for determining how to distinguish between the cost of land versus the cost of structures. |
The Internal Revenue Service included guidance in the 2008 version of the instructions to Schedule E on resources available to taxpayers for determining how to distinguish between the cost of land and the cost of structures.
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| Internal Revenue Service | To help taxpayers understand the requirements related to certain aspects of reporting rental real estate activities, the Commissioner of Internal Revenue should include guidance within the instructions to Part I of Schedule E on recordkeeping requirements and the potential for disallowed expenses and penalties if taxpayers cannot produce documentation for reported expenses upon examination by IRS. |
The Internal Revenue Service (IRS) included guidance within the 2008 versions of the instructions to Schedule E on recordkeeping requirements and the potential for disallowed expenses and penalties if taxpayers cannot produce documentation for reported expenses upon examination by IRS.
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| Internal Revenue Service | To enhance IRS's outreach efforts, the Commissioner of Internal Revenue should evaluate whether sending notices to some or all taxpayers who report rental real estate activity would be a cost-effective way to reduce misreporting of some types of rental real estate activity. |
IRS stated that it will use notices for taxpayers reporting rental real estate activity, as it has determined that the notices appear to be a cost-effective way to reduce misreporting of some types of rental real estate activity. IRS further stated that it will monitor results and adjust future treatment as necessary to ensure compliance coverage using the best treatment system.
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| Internal Revenue Service | To enhance IRS's outreach efforts, the Commissioner of Internal Revenue should expand outreach efforts to external stakeholders, such as paid tax return preparers, tax return preparation software providers, and industry groups related to rental real estate, to include common types of misreporting for rental real estate activity, such as those identified in this report. |
IRS agreed to develop an updated fact sheet rental real estate issues that will include common types of misreporting to use as an outreach tool. IRS posted the fact sheet to IRS.gov and distributed to external stakeholders in July 2009.
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